Today, an individual ‘transacts’ with multiple entities every day, either offline or online. Immaterial of the size or nature, however, a common underlying feature of transactions is that they require the parties involved to trust each other or adhere to a system that enables this trust to be executed. These ‘trust systems’ can take a variety of forms, depending on the nature of transactions being executed, to create checks and balances to ensure that parties involved fulfil their responsibilities and recourse, in the case of disagreements, is available.
In the assignment of a job to a vendor for a construction project, for example, trust is encoded in contracts enforceable by law. ‘Escrow accounts’ can be seen as another instrument to create trust.
Banks and Financial Institutions are perhaps the most well-known of these systems, existing largely to facilitate the creation of trust while transacting in money. Regulatory bodies and certain government agencies exist almost exclusively to establish enforceable guidelines or regulations to create trusted environments for stakeholders to transact.
These ‘trust systems’ have become increasingly complex with development and growth, the complexity of these systems has increased, making them more susceptible to inefficiencies. India, specifically, has not fared well in indicators to measure the efficiency of processes to ensure trust. Blockchain presents the potential for achieving this.
Enter Blockchain – a new paradigm of trust
In 2008, a technical white paper was released to describe the design of a new ‘Peer to peer electronic cash system’ called Bitcoin. The paper argues that the traditional trust-based payment models, with the possibility of reversals, lead to high transaction costs and increase the level of intermediation required by a ‘trusted third party’ (in this case, a bank). it is the paper on the Bitcoin that is most credited for the advent of the new technology.
What is a Blockchain?
Blockchain is a digital, immutable, distributed ledger that chronologically records transactions in near real-time. The prerequisite for each subsequent transaction to be added to the ledger is the respective consensus of the network participants (called nodes), thereby creating a continuous mechanism of control regarding manipulation, errors, and data quality syncing within minutes/seconds; adjustably Transparent Records stored in the database may be made visible to relevant stakeholders without risk of alteration; highly Secure, hackers can no longer just attack one computer and change any records; and Immutable The mathematical algorithms make it impossible to change/delete any data once recorded and accepted.
Blockchains leverage techniques from a field of mathematics and computer science, known as cryptography, to sign every transaction from one person to another with a unique digital signature belonging to the user who initiated the transaction. These signatures are held privately but are verifiable publicly. This means that if a user with identity A sends an asset to identity B, anybody can verify that the asset was sent by A, but cannot use A’s signature for their own transactions.
This cryptographic system creates accountability while preventing identity fraud: if you send assets or update information on a Blockchain, you later cannot claim otherwise or shift the responsibility for the action. Blockchain also enable the creation of ‘smart contracts’, defined as self-executing contracts with the terms of the agreement between the buyer and seller directly written into lines of code.
The code and the agreements exist across a distributed, decentralized Blockchain network. The code controls the execution, and transactions are trackable and irreversible.
Unlike present day networks that depend on trusted intermediaries for security and trust, Blockchain thus creates trust organically through the underlying technology of distributed networks. They allow users to exchange digitized assets directly, in a way that is incorruptible and transparent (timestamped) ledger, with the identity of the person who committed the transaction
Gartner, the research and advisory firm, defines five elements of a true Blockchain: Distribution, Encryption, Immutability, Tokenization and Decentralization.
Blockchain Vs Distributed Ledger (DLT): Blockchain is part of a broader suite of technologies called Distributed Ledger Technologies (DLT). Though often used interchangeably, Blockchain technology and distributed ledger technology distinguish themselves in their structures of data storage.
Blockchain can be considered a subset of DLT in which multiple transactions are stored in ‘blocks’ and cryptographically linked to the previous block by a ‘chain’.
What is Blockchain in Banking & FI sector?
Blockchain is basically a distributed ledger. It can store data like, who owns a particular piece of land or say a bond. The technology can be used to keep an immutable record of ownership and enable transaction of the asset amongst distrusting parties.
Why is Blockchain important for banks &FIs?
Blockchain technology offers transparency and verifiable financial transaction with ease. With Blockchain in the financial industry, individuals and banks can access their transactions. This helps the financial institution to know their customers via transparent and verifiable transactions.
Bank for International Settlements (BIS) characterized cryptocurrencies through their three fundamental features:
- They are electronic
- They are not liability of anyone
- They allow peer-to-peer exchange
The most basic form of currency transaction is the use of cash – a peer-to-peer to exchange system, albeit not electronic. Every sale of goods and services happening at a mom-and-pop store is effectively a peer-to-peer exchange of value. WWW enabled decentralized mechanisms of exchanging information and value at a global scale.
All of these systems are well recognized by governments and regulators. There are umpteen areas of exchange where decentralized systems are the most value-creating mechanisms of that exchange. Blockchain and other DLTs enable the building of decentralized systems, thus creating tremendous economic and social value.
Role of Cryptocurrencies in BanksBottom of Form
A cryptocurrency is a digital or virtual currency designed to work as a medium of exchange.
It uses cryptography to secure and verify transactions as well as to control the creation of new units of a particular cryptocurrency.
During the 90s tech boom, products like Flooz, Beenz and Digi Cash emerged but failed. In early 2009, an anonymous programmer Satoshi Nakamoto introduced Bitcoin.
Usages of cryptocurrency
1. Buy goods: There are a lot of merchants – both online and offline – that accept Bitcoin as the form of payment. Bitcoins can be used to pay for hotels, flights, jewellery, apps, computer parts and even a college degree.
2. Invest: Many believe that cryptocurrencies are the hottest investment opportunity currently available.
Bitcoin is the most recognizable digital currency to date and in November 2017, the price of one Bitcoin went up to USD 7,000 from USD 800 five months ago. However, cryptocurrencies are high-risk investments.
Bitcoin is obviously still the dominant choice to invest. It’s very easy to buy Bitcoins – there are numerous exchanges in existence that trade in BTC. All major exchanges offer wallet services for storing. It is best if it is stored in offline wallet for best security.
3. Mining: Miners are providing a bookkeeping service for their respective communities. Mining is an investment activity.
They solve complicated cryptographic puzzles, which is necessary to confirm a transaction and record it in a distributed public ledger called the Blockchain. Many people have made fortunes by mining Bitcoins.
Legality of cryptocurrencies
Presently, Bitcoin and other digital currencies are illegal only in Bangladesh, Bolivia, Ecuador, Kyrgyzstan and Vietnam.
Position in India: Originally, RBI had banned in April 2018 use of digital currency but Supreme Court on 4.3.20 has lifted the ban.
How to buy: There are many different options when it comes to buying Bitcoins. For example, there are currently almost 1,800 Bitcoin ATMs in 58 countries. Moreover, one can buy BTC using gift cards, cryptocurrency exchanges, investment trusts and you can even trade face-to-face.
Menace of Fraud-Urgent propellant for DLT in Banks & FIs
An analysis of frauds that happened in Banks & FIs in India during 2015-20 indicated the following vulnerable areas:
- Money Laundering/Black money sent abroad
- Debit/Credit Card frauds/Fake Demat accounts
- Benami accounts/Forged Stamp papers
- KYC Violations/KYC frauds/KYC Updating
- Cybercrimes/Identity Theft
Tech frauds are on the rise where the fraudster operates anonymously and from outside. Analysis has revealed the top 3 technology related frauds happen through: I-Net/ATM/E-Banking/Identity fraud.
DLT Foray in Banks in India
With several leading banks proactively investing in Blockchain platforms as part of their digital transformation initiatives, the Indian banking sector is set to witness growth in the mainstream use of Blockchain technology in 2020 and beyond, says GlobalData, a leading data and analytics company.
Major issues that Banks & FIs face today?
The Indian banking industry today is faced with issues such as rising costs of operations, increasing susceptibility to fraudulent attacks on centralized servers and challenges in ensuring transparency.
What are Banks looking for?
Banks are continuously exploring new ways to perform transactions quicker for enhanced customer service while ensuring cost efficiency in its operations and assuring transparency to customers and regulators. For this, Blockchain potentially provides a solution for banks as it inherently helps eliminate intermediaries, maintain an immutable log of transactions and also facilitates real-time execution of transactions.
This could potentially reduce the TAT for a banking transaction, reducing costs of manual work, and leading to enhanced customer service and satisfaction. Like any other industry, choosing the right ‘use case’ is the key for Banks to leverage the full value of Blockchain.
Progress Card in DLT in Banks in India – An update
SBI has tied up with PrimeChain, a startup and created a consortium of leading Indian banks called “BankChain” to research the potential of Blockchain in banking. SBI has been working on the use of Blockchain technology for remittances, reconciliation and trade finance. The company has already rolled out Blockchain-based smart contracts and KYC solutions. By 2030, SBI is planning to put all the core transaction-related processes on a Blockchain.
ICICI, Axis and Yes Bank, which have been at the forefront of Blockchain efforts in the country, have joined JP Morgan’s Blockchain platform, ‘the Interbank Information Network (IIN)’ in September 2019, which enables faster cross-border payments by providing secure exchange information to banks at a lower cost.
Earlier in 2019, 11 Indian banks, including ICICI, Axis, Yes Bank, HDFC, Kotak Mahindra, Standard Chartered, RBL and South Indian Bank, have formed a consortium to introduce and run a Blockchain-linked loan system for SMEs in the country. Bank of Baroda, the State Bank of India (SBI) and IndusInd Bank are involved in this consortium as outside members.
ICICI Bank, for instance, on-boarded over 250 enterprises on its Blockchain platform for domestic and international trade finance in 2019, besides engaging with 10 more banks in a consortium established for leveraging DLT platform.
The bank also deployed Blockchain technology for automating inter-bank processes for trade finance and remittances, which helped it not only to reduce the processing time and transaction costs but also resulted in cutting down the use of paper at an industry level.
Benefits to banks
Improving profitability and quality
- Automation using smart contracts/algorithms
- Traceability of all historical transactions
- Speed and efficiency of transactions by eliminating intermediaries
- Enhanced security by encryption of data at the stage of dissemination
- Prevents tampering as any tampering may leave behind a trail
- DL Provides a comprehensive picture:
- All stakeholders see the same
- Information to which they have access
- Availability of multiple copies of the shared data
Reinventing products and processes
Transparent and predefined rules which facilitate creation of new products/processes through a decentralized model Tokenization/Digital Assets which are physical objects with a unique digital representation that enables digital ownership, management and transfer.
Quicker KYC for the Clients
Blockchain can facilitate immediate KYC by the Lead Arranger through digital identity for clients technology integration automated due diligence and analysis of information for loan underwriting through Blockchain, reducing TAT settlement periods.
Blockchain can facilitate near real-time loan funding and payment settlements with activities executed via smart contracts.
Immutability feature of the Blockchain eliminates the need for multiple copies of the same documents being held Implementation of Blockchain would lead to cost savings in the range of 70-80% for a syndicate loan transaction facilitated by banks
Blockchain helps eliminate the manual steps involved in the company’s bill discounting process and the entire transaction becomes paperless. Real-time settlement of transaction Clients can transfer invoices to the Blockchain network using an external technology such as Oracle and once it is on Blockchain, smart contract rules can be triggered, and then the bills are discounted and funds disbursed to the vendor within few hours.
An automatic debit to the customer account is triggered on the due date. Real time tracking of the transaction with the transaction being up on Blockchain, all the relevant parties can view and verify the processes.
DLT enables all the relevant parties to view and verify the processes. There is only one source of truth and transactions cannot be processed further unless all the relevant parties agree and authenticate it.
Currently, banks will have to opt for a permissioned or closed-loop Blockchain with smart contracts (which in this case would be code-driven, a tripartite agreement between banks, clients and vendors).
Customer loyalty programs
Loyalty/reward points are an integral part of the customer retention strategy across industries, and especially for banks with significant retail business. Reward points help in tokenizing a portion of the customer’s spend and using it to increase stickiness.
Cross border payments
Sending an international payment across existing banking networks is a complex, multistep process involving multiple intermediaries. With cross border payments amounting to $600B annually, having a growth of around 3% a year, driven by international trade, the cost of processing these payments is extremely high. Fees range from 2 to 3 % of transaction value and can be as high as 10%.
Blockchain addresses these challenges by streamlining the process and storing every transaction in a secure distributed ledger. The moment a transaction is recorded, the receiving party has access to the payment without any intervention of middlemen, no delays and no unnecessary fees. Once payment is entered, it can’t be reversed or changed in the ledger, resulting in greater overall accountability and security.
Today, several trades are going through a settlement process that spans days, due to multiple intermediaries. Setting up a trading platform on Blockchain offers a new mechanism, for the exchange of assets without centralized trusts or intermediaries and without the risk of double-spending. Once certain specified terms and conditions of the agreement have been met, the smart contracts will automatically be executed, and all actions carried out by the parties concerned can be viewed
Challenges in implementing DLT
- Nascent technology: As most of the firms are still experimenting with Blockchain and trying to develop PoCs, there is a high chance of failure due to lack of any precedence.
- As such, identification of a use-case by the bank will not suffice.
- Bank will have to consider other allied factors such as transaction speed, verification process, codes for smart contract and data limits.
- Clarity around regulatory status: As a few of the use-cases involving Blockchain as a solution, require the use of virtual currency to perform the transaction, regulation changes are required from GOI and RBI
- Another regulatory issue relates to smart contract mechanism of Blockchain. While incorporating the smart contract mechanism in their solution, the issue of traditional concepts of a contract such as an offer and acceptance, certainty and consideration come up. Need to ensure its legal enforceability.
- Integration procedure and change adoption: Blockchain applications offer solutions that require a significant overhaul of existing systems. In order to make the switch, companies must strategize the transition.
- It needs to be a consortium-based approach as banks need to make sure that all the relevant stakeholders for the underlying use-case agree to come together on the platform.
- This will require conducting workshops with the stakeholders and educating them about usage and usefulness of Blockchain-based system.
- Cost: Blockchain offers tremendous savings in transaction costs and time but the initial cost of investment in the technology might be high and the payback period might be high.
Technology is truly controlling the way we live and transact especially in the financial world. It has brought huge benefits and a few viruses along too in the form of a security breach and ID theft to pave way for digital frauds. Blockchain looks to be the omnipotent antidote for these ills.
It has arrived at the exact moment we need it. Banks & FIs are the massive pillars of trust the society leans on and they need ring-fencing against these viruses urgently.
Already a hoard of Banks has started embracing Blockchain and leads the way for others to follow. Like the consulting firm Gartner said, the next decade belongs to Blockchain in Indian Banking history and we will be the witness to a 100% transformation by 2030.
About the Author
K.Venkataraman is a senior professor at Manipal Global Academy of BFSI. He is a multi-talented person – a banker, an advocate, faculty in many educational institutions. He retired as an executive from Canara Bank after serving the bank in various managerial capacities for 34 years.
Prof. Venkataraman holds an MBA in HR, and LLM besides many certification and membership in Karnataka Bar Association. He is a faculty in ICAI, Bengaluru, conducts online classes for business administration students of Sikkim Manipal University and he is a viva panel member in four universities. He also works as an IPR consultant. Since 2011, Venkataraman working with Manipal.